Avoid the Tax Train Wreck

I recently received two separate calls concerning transferring family businesses to the owners’ kids. Both callers had gotten the same wrong advice. After a wrong estate plan, a wrong succession plan for a family business can create the most tax pain and havoc for the family.

Wrong transfer plans are expensive, can rarely be fixed and are unnecessary. Only the IRS and lawyers profit. This step-by-step solution will ensure that your family never suffers the sad consequences of a bad transfer plan.

The Facts
Joe is in the highest income and estate tax brackets. His business, Success Co., has been professionally valued at $14 million.

Joe’s son, Sam, has been running Success Co. for years, with some help from Joe. After many meetings with his CPA and lawyer, Joe decides to sell the company to Sam for $14 million, payable over 10 years, plus interest at 4 percent. However, after Joe’s advisors explain the tax cost of the sale of Success Co. to Sam, Joe goes into a state of shock, then calls me for a second opinion.

As I explained to Joe, each $1 million of the sale price of Success Co. will be socked with three taxes: 1) Sam will actually have to earn $1.666 million to cover each $1 million, because the 40-percent federal and state income taxes will nail him for $666,000. 2) When Sam pays Joe the $1 million (assuming a zero tax basis), Joe will be hit with a 20-percent capital gains tax that gives the IRS $200,000 and leaves Joe with $800,000. 3) At Joe’s death, the IRS will siphon off another 40 percent of that $800,000 for estate taxes, leaving just $480,000 of the original $1 million. So, Sam must start with $1.666 million for Joe’s family to ultimately receive $480,000.

(The amount of income tax may differ, depending on the business owner’s state of residence. These rates vary from zero in Florida and Nevada, to 11 percent in Hawaii. In addition, 20 states and the District of Columbia also impose a state-level estate or inheritance tax. Indiana’s is the highest at 20 percent.)

The Solution
The right way for Joe to transfer ownership of Success Co. to Sam and maintain control of the company is through the use of voting and non-voting stock, a two-step strategy.

Step 1: Joe exchanges all of his common stock for two specific types of common shares: voting common (say, 100 shares) and non-voting common (say 10,000 shares). This transaction, called a “recapitalization,” is tax-free.

Step 2: Joe sells or gives the non-voting stock to Sam and retains all the voting stock. He then owns less than 1 percent of all the company’s stock, yet retains 100 percent of voting control.

Discounts Are Your Friend
The non-voting stock is entitled to three distinct discounts because of this type of stocks:

1. Lack of marketability. The sale of publicly held stock requires little more than a phone call to quickly put the proceeds into the hands of the seller. A privately held company must first find a buyer and then agree to terms.

2. Minority interest. Not being able to vote is the same as having a minority interest—you do not have control.

3. Lesser value than majority stock. Courts have consistently held that a share of non-voting stock is worth less than a share of voting stock.

Typically, the non-voting stock discounts total about 40 percent. So, for tax purposes, the value of Sam’s 10,000 non-voting shares of Success Co. is only $8.4 million (40 percent of $14 million).

The Magnificent IDT
Using an intentionally defective trust (IDT) to facilitate the transfer of stock from Joe to Sam will offer additional tax benefits. An IDT is an irrevocable trust that is not recognized for income tax purposes.

Here’s how it would work in Joe and Sam’s case: Joe sells all the non-voting stock in Success Co. to the IDT at its fair market value ($8.4 million after discounts). Sam is the beneficiary of the trust. The IDT pays Joe with an installment note for $8.4 million, which also bears interest. Success Co.’s cash flow is used to pay off the note, plus the interest. (The company, which must be listed as an S corporation, pays tax-free dividends to the IDT, which in turn pays Joe’s note.)

What makes an IDT magnificent is that all the money Joe receives from it is tax-free—no capital gains tax on the note payments, no income tax on the interest.

And what about Sam? He doesn’t spend a dime, but when the note is paid in full, the trustee will distribute the non-voting stock to him (tax-free). Or, if Sam is married, the trustee will keep the stock in the IDT to protect the shares in case Sam later gets divorced.

Depending on the tax rate in the business owner’s state of residence, an IDT can save 
about $190,000 per $1 million of the stock price. In the case of Success Co., which had a stock price of $8.4 million, the tax savings will be about $1.6 million.

Of course there are other benefits, tax traps and nuances associated with IDTs, so you should work with an experienced advisor who knows their ins and outs.